This past summer has had some immediate exceptions.  Drought in the middle west of the US coupled with poor harvest yields in South America combined to push dollar denominated grain prices to new record highs.  Those highs, while reached some six weeks ago are fundamentally based on assumed supply shortages.  The proportionality for grain prices to stay high, however,  is rather low as both export markets and global pricing regimes work in tandem to either 1) lower demand or 2) add supply.  Again – its worth noting the transitory nature of price rises in this corner of the commodity complex and to adjust expectations accordingly.

The broader market segments shown above illustrate neatly the move we have seen in anticipation of further easing.  The rather lackluster nature of this years move to previous years suggests that the Rule of 3  seem to be peeking its head over the wall.  Peter Tchir recently wrote a well timed piece on this idea that ostensibly says “once even your mother knows what’s going on everyone does” and so the effect end of the “cause effect” may be significantly diminished.

Might this now be the case?  How much effect will a weak US Dollar have on commodity prices?  How strong is the final demand picture?  Inquiring minds want to know.

Perhaps this is most readily seen in the crude oil chart.  External factors seem to be driving the price of crude more than monetary policy and to that end final demand.  It is clear that global energy demand is down and with it crude from last spring’s highs.

To that end you will note that Gold should be well through $2500 by now if we are easing for 3x and have now asked Mario Monti and his band to open the concert with their version.  (Mind you sterilized anything just doesn’t seem so sexy.)

The conclusion of all this is two fold but have implications that cast a very wide net indeed.

a) Monetary policy takes time to work

b) Monetary policy has limits

No one really likes either of these conclusions, especially in an election year.

And so we are now left to sit and ponder which way the complex will go.  So far the law of diminishing returns seem very much at play.

When we sat down to create a series of long/short investment vehicles in the commodity complex we wanted to have a number of key drivers in place.  Here are the principles we established to guide our analysis going forward.

1) There is no commodity complex – there are many commodity complex(S)

2) Julian Lincoln Simon and Paul Ehrlich – we take Julian’s side in the great debate.

3) Fundamentals matter in both the short and long term – the middle term not so much

4) Duration for each part of the commodity complex is vastly different one to the other

1)  There is no commodity complex

This point is at the top of the list mostly thanks to our consumption of daily business news.  Whether it’s TV, internet, or buy and sell side research the propensity to make a “call on commodities” may be strong but it is wrong headed, and can cause one to misinterpret important data that affects long term outcomes and decision making.

Here’s a good recent example:  S&P GSCI (broad commodity index) v. the Grain Based DBA Deutche Bank

I’d love to be in grains – the balance of commodities… not so much.

2) Julian Lincoln Simon and Paul Erlich’s now famous bet about commodity prices is a foundational macro point on which a great deal of analysis around general theories of productivity should turn.  Unfortunately this part of the equation often gets overlooked and thus productivity gets over or under stated accordingly.

Simply put, we believe that on a currency adjusted basis the long term trajectory of commodities is subject to supply and demand constraints that spur productivity and cause innovation.  That innovation, in turn, sees prices – generally – beaten back (again on a currency basis).

The most obvious instance of this in recent memory is Nat Gas – represented here by the ETF UNG.  Ouch….  Oh, and we keep finding more and more.

3) Fundamentals matter in the Very Near term and Very Long term.  The challenge is understanding pricing in commodities over two time frames – a) Calendar and b) economic cycles.

Front month pricing is the penultimate example of baseline supply and demand.  Most market participants use this information for feedback on the current state of the global economy.  The back month pricing is where more of the analytics and crystal ball gazing takes place.

When one looks at the price divergence across those two time frames one notes the propensity of people to equalize the two inputs.  It is our long held belief that such a practice does not help clarify the current state or even the 3 – 6 month forward state of global economic affairs.  Rather we see an information deficit divergence that can be a major hurdle for understanding forward price regimes and cloud additional capital deployment.

4) Time matters

Our last pillar ensures that we are taking as Peter Schwartz suggested in his seminal book from the 1990’s a “Long View.”  While current prices suggest various outcomes in the current economy, they also dictate what happens in the long run. Price distortions due to drought, technological innovation and/or Central Bank policy can all turn away as quickly as they arrived.

What we’ve discovered to be important is to always allow for a notion of time in one’s analysis of near and longer term pricing in the commodity complex.  This allows for a more nuanced analysis of where we are and what is likely to be next for the global economy.

On current pricing

We continue to see significant deflationary tendencies across the global economy.  Of late, the stampede into this notion has been hard and fast.

This suggests to us a bit of a bottom in that data set as the media tends to be very late to this story.   We know our colleague Dan Alpert has been putting the table on this for over four years.

While we are not suggesting the re-ignition of a global commodity “super cycle” we are noting that prices seem to now reflect a lower growth environment.  To our mind this reflects recent follow up work from Reinhart & Rogoff.

In a recent follow up paper the authors – Reinhart & Rogoff – find that prior instances of debt levels above 90% of GDP are associated with an average growth rate of 2.3% (median 2.1%) versus 3.5% during lower debt periods. Notably, the average duration of debt overhang episodes was 23 years, implying “a massive cumulative output loss.”

On a final note this morning more data suggesting that we are bouncing along a very dangerous bottom, one in which the floor may actually fall out and there would be a fairly far way to drop.

July PMI numbers suggest a further decline through the summer although not quite as steep as the Industrial Production numbers would suggest.  The question one needs to ask here is whether or not the steep decline in industrial production is lead by inventory levels of significant weakness in consumptive demand.

As we noted in the top of this post we see nothing short of massive deflationary forces as the culprit behind the complex wide – save grains – decline in commodity prices.  The lack of wage stability in both the emerging economies and the developed economies suggest that further broad based economic demand will continue to remain soft.

To be honest there really hasn’t been much to say.

Stocks took a hickey ten days ago only to finish up on the week for the 10th straight week in a row.

Yawn

And in the “Yawn” lays the problem.

Perhaps this explains all we need to know.  For over three decades the US math and science scores have been plummeting and at the same time we’ve had three major market bubbles and crashes.

Coincidence?  I don’t think so.

We used to have to study and pass exams.  Now we get extra help and get passed along with our tutors in tow – not that we ever listen to them.  No, rather they are there to explain the mess to us when it happens becuase we couldn’t figure it out when it was exploding in our faces.

Ok – so there’s the rant this week.

I think equities are now some 5-7% overvalued based on 2012 full year earnings and probably another 10% over valued based on 2013 earnings which will be awful because a tax increase is coming as will fiscal austerity – no matter who gets elected in November.  Between then and now expect another showdown over the debt, balanced budgets and a whole assortment of things things that will shock investors back into the real world.

It is also worth noting that the only large institutional head in the world that I trust, Christine Lagarde, Head of the IMF, said over the weekend that the European Crisis is not over.  We’ve been saying this since the first version of the second Greek bailout was revealed in November of 2011.  Glad she caught up with us – the markets will too and caution should not be thrown to the wind.

S&P 500 2011 vs. 2012

Amazing!

Astounding!

Terrifying!

We start off the New Year with no shortage of adjectives to describe the month in markets that was January.  While it remains unclear how broad the participation has been and to what degree the strength is sustainable, there is no question that investors, helped by the world’s central banks, moved out on the risk curve to produce a very impressive run across almost all asset classes.

This month we need to look over three issues:

-          Shrinking Profit Margins

-          Rolling over debt

-          Election Cycles

The reason we are focusing on margins is because they are at historically high levels and we are wondering a) how long they can stay there and b) if they can’t what it means for equity and bond valuations going forward.  Second we look out to the roll over of close to 1 trillion Euros this spring – with a big chunk of that coming from Spain and Italy – Ay Caramba &  Mama Mia!  Finally, as we enter the election year I wanted to revisit an old barometer of return that we look at year in and year out.

The Recap

While global bond markets took a well deserved pause, equity markets picked up the slack clocking one of their best Januarys since the mid 1980s.  Incidentally that’s when the credit bubble, that caused the mess we are in, took root.

At any rate the power of the index led rally was not to be ignored.  Better than expected data at the beginning of the month combined with the traditional beginning of year asset RE-allocating and that was all the fuel markets needed to complete one of the best six week periods in the history of equity markets.

Incredible Disappearing Margins

At Strategic we watch a number of indicators to help us understand where one is most at risk and where one might be best positioned both in terms of offense and defense.  Investors have learned in recent years its helps to be good on both sides of the line.

To that end we review data sets like weekly tax receipts,  slated public and private building projects and of course the old corporate margin or two.  Something that we noticed as we begin earnings season mid-month was that margins seem to have not only topped out but they seem to be shrinking dramatically depending on the sector one puts under the microscope.

Our first two charts this month – courtesy of our pals at Goldman Sachs show us that as of the end of the month we are witnessing a topping out of the margins and margin expansion.  While there are some sector eccentricities its worth understanding that elevated levels of margin and or continuous growth in margin expansion in mature companies – like those that make up the S&P 500 are very rare periods of history indeed.

Topping out?

Our second illustration shows us that Q4 earnings are tailing off from Q2 and Q3 upside surprises to a more normalized rate of earnings distributions.  One of the eccentricities that we like to point out is that capitalization weighted indexes can have very peculiar behavior when only a handful and in more recent times only one of its constituents performs well.

This month’s spotlight then falls on the tech darling of the last decade – Apple.  The stunning earnings growth reported by the company formerly lead by Steve Jobs was nothing short of jaw-dropping.

Even with the boost from Apple, the blended (reported & estimated) aggregate Q4 earnings growth rate for the S&P 500 remains well below the 15.0% level computed in early October 2011. Two of the biggest contributors to this decrease are the Materials and Financial sectors. The Materials sector growth rate dropped from 25.6% to 10.4%. This drop is primarily driven by Alcoa’s 114% plunge in net income. Additionally, most commodity prices (with the exception of copper) continued to fall in response to macroeconomic news and seasonal trends.

The point here is to look under the covers and make sure you know what you are paying for as investors.

Rolling it Over

“Don’t worry, she’ll hold together… You hear me, baby? Hold together!”
―Han Solo, talking about the Millennium Falcon

Why is it that the current debt rollover situation seems eerily like the moment quoted above in Start Wars?  One has the distinct feeling week after week that the brash and uncalculating Merkozy has no idea if the coming rollers in the Spring of this year will impale the Euro and the Eurozone once and for all.

We happen to think that it will not but the reason for why and what the market consequences are produce a very different outcome for investors based on how one is positioned.

If the EU can get this year rolled over and “muddled through” then the balance of the world stands a chance of making it through 2012 whole.  Given what we’ve seen out of Europe in the post 08/09 environment we think it wise to be ready to any turbulence that may be unforeseen – Millennium Falcon not withstanding!

As we finalized our January copy there are rumblings of a “final deal” on the Greek situation.  We wondered aloud in 2008/09 about the kind of moral hazard that saving the banks would produce only to witness the “reality distortion field” of  2011 produce bizarre correlations, promises and fantasies.

Unfortunately there will be fewer fantasies this time around and we now wonder allowed if the other Sovereigns will balk at paying par back when its time to roll over their paper.  This is a very dangerous precedent to set if we see a writedown without default.

As many before have said in various iterations – Capitalism without failure isn’t capitalism.

Cyclical – This time it’s Elections

For the past two notes I have threatened to talk about Presidential Cycle returns.  I made mention of this phenomenon last year at this time when we predicted a low return year for equities.  Our prediction was based on lower GDP growth rates but also in part to the notion that over a four year rolling period one tends to see a normalized distribution of returns numbers – ON AVERAGE.

To us the fact that investors thought that they would be entitled to the rather high level of customary “third year” returns was incongruous to us with the fact that much of their desired return had already been provided to them in years 1 and 2 of the current administration.  Who you credit with those returns is your own business – all we know is that distributions of returns normalize and so to us it made sense that we had already borrowed forward a number of those pieces.

Concluding Thoughts

And so it is that we think we have borrowed a good deal already this year.    Having seen the same pattern emerge for the last three years reminds us that the rise in January is nothing new.  Taking chips of the table looks to be a prudent move.  Staying defensive while there remains a lack of clarity may also be reason enough to step to the side.

Last year it was Fukushima that broke the market’s back.  This year we suspect it will be something equally unanticipated.  And for those reasons, we choose to anticipate.

10 x 12*

A set of macro thoughts for the Year 2012

A single theme guides our thoughts in 2012:

There are no more surprises in this Topsy-Turvey world.

In fact, it would be a surprise to us if there were no surprises in 2012.

1) Market v. The Fed – Long duration US $ Bond Prices Dramatically Fall

The long held maxim of “don’t fight the Fed” gets its first in what will be a string of tests from “the market.”  This results in long dated US Treasury Bonds moving north of 5% and 10 Years break 3.5%.

2) Emerging Markets a little less Emerging –EM Equity and Bonds Perform Well

In line with our long held ideas around global re-balancing, we see emerging economies – particularly, but not exclusively those in the BRIC countries (ex Russia) – performing well in 2012.  More intramural trade as well as moderate growth in domestic demand will combine in a powerful economic 1-2 punch of growth.  The world will also begin to seek out those less-indebted economies as a new “search for yield” grips confounded investors.  +9% in Equity and +4% in Bonds.

3) The October Surprise

The US launches attack on Iran during 2012.  In addition to concerns about Iran’s nuclear ambitions, continued threats of closing the Straits of Hormuz combined with saber rattling in the form of missile tests provokes an armed confrontation between the US and yet another Middle Eastern power.  Oil briefly visits $130

4) Natural Gas Triples

Further illumination of the relationship between hydraulic fracturing  – or “fracking”- and earthquakes forces State and the Federal officials to put a halt to the majority of fracking operations in the US causing Natural Gas prices to triple.

*Thanks to Mike Bennan at  for helping clarify our Natural Gas thoughts.

5) Europe

Much like our muddle through call for the US last year we see Europe following in the US’s footsteps and muddling through.  While the current EZ and EMU pacts are to be sure flawed, they are not, conceptually, a bad idea.  Europe and the Europeans themselves have much to gain from a single monetary union and more importantly a single enforceable set of fiscal policies.  That said, if the ECB prints Euros, European equities will print double digit returns.

6) Obama wins 2012 General Election in landslide larger than 2008

The administration comes up with 3 very simple charts to illustrate to the American people that they are better off than they were in 2008/09 period.  They are:

• S&P 500 – Sitting at 1300 in Oct
• Unemployment – hovering at 8.2% in Oct
• Number of US jobs “re-shored” from 2009-2012

7) Euro Survives and after making a short appearance at 1.10 makes a run at 1.50 v. $

Despite calls for Euro Parity we think not only does the Euro survive but in a competitive race to devalue currencies Ben Bernanke wins every time.  Peripheral countries begin to show signs of stabilization and the initial Euro weakness catches a bid as investors realize unfunded liabilities higher taxes and State & Local US finances are a much bigger mess than currently understood.

8. American crop yields surpass all-time highs and set new price floors

Julian Lincoln Simon emerges from the grave to witness The Ultimate Resource in grain yields of 164.7 in Corn and 44 in Soybeans.  The price floor comes out of renewed demand from the emerging economies but not until the second half of 2012.

9) China’s Next Fixed Investment – Agriculture

As the property bubble burst, the Central Planning organization in China will focus on ways to improve farmland productivity.  This will cause another counter cyclical rally in terms of US and European durable goods shipments to the “lone star” country. It will also contribute to the aforementioned drop in Ag prices.

10) Global GDP

Unfortunately like last year we will see rather sluggish GDP growth in 2012.  We think 2.3-2.7% for the US, a mild recession for the Euro Zone and 3.5% for the globe.

*This year’s title comes from the actual size of my apartment in New York while I attended graduate school in the early 1990s.  We are happy to report that I now live in slightly larger accommodations.

- Strategic Financial Group

Investment Advice offered through Strategic Financial Group LLC, A Registered Investment Advisor.

So, here’s my take.

There are a number of items of note from last week’s EU Summit. While naysayers spent their weekend spilling ink to tell us all how hopeless the situation is and how the EMU and the Euro will go the way of the Simca we think it’s a bit more complex than “the sky is falling.”

Indeed, last week’s moves were significant on a number of fronts.  The ultimate outcome rests on being able to operationalize a good deal of what has been put on the table over the last six months. We believe that a workable outcome is in the cards.  The option to fail is far more costly than that of a union that is disciplined in the future.

Our analysis of the current situation and a peek into what the backside looks like is below…

Time

A number of pundits spent space telling us that “time” is of the essence.  However, in this case time is relative to confidence not to action.  Yes, words need to be followed through with action and yes, it takes a ton of time to get things through the current treaty structure – we get that.  However the issue is one of longer-term confidence and that can only come when Europe is collectively committed to a series of more responsible fiscal policies.  It is worth noting that Germans got it right from the beginning.  There has been very little “finger pointing” or accusations just a steady stream of potential fixes and ideas that lead down the path to tighter fiscal integration.

Integration takes time.

Culture Wars (Euro Style)

Two – It’s the 21st century get over your “culture” arguments.  The world is a big massive competitive capital market – even the communists are capitalists now.  With this one has to significantly question the long embedded ideas of sovereignty and national identity and that they would actually be “giving something up” to Brussels.

Yes, we can have a sense of who we are as a people and what we like to value but you have to budget responsibly within those proprietary priorities.  No Maude – you can’t have it all.

More importantly the kind of shenanigans that the UK pulls at every summit should get them permanently removed.  If they want to be the banking center of Europe and have lower regulation and higher pay and watch the City blow up the UK and other parts of the world – GREAT!  Guess what? Capital tends to figure out risk pretty quickly and when it doesn’t it gets wiped out.  Those are the rules and they have very little to do with Bulldog British-isms or French Farmers or Greeks who like to retire at 55.

History – Everyone has a past – get over it!

Third – Hey guys!!  World War I & II were over 60 years ago…. could we move on?  Banks not Tanks?  Really?  How about responsibility instead of decade’s of rather fallacious behavior?

The whole idea of the EU and the EMU is scale… If you didn’t get that back in 1998 you shouldn’t have signed up.  When you run the numbers the EU is a bigger economy with a higher GDP output and a lower level of debt than the US.   (You have to include the US debt at the State level for this calculation to work) And so, the argument goes, levering up that collective set of numbers should be good for every one.

As we now know it only works if everyone plays with the same rulebook.

Everyone is Guilty – Vendor Financing

Fourth – Germans have to own up to their part in this too.  They knew damn well that by collecting the whole of the EU’s balance sheet and lending against it they could engage in what is typically known as vendor financing.  Everyone gets a lower rate and they buy Germany’s awesome cars and coffee makers.  It’s great until credit gets tight… MAN THAT SOUNDS FAMILIAR…

Now, to be sure, I don’t think we need to think of Germany as Countrywide and certainly Merkel’s no Mazillo (ewwww) but there is a bit of truth to this “devilish” pact that was implicit during the good times in the mid 2000s.

Discipline

Fifth-It remains clear that prior to loading the Bazooka, saving the banks and promising to backstop “Paulson Style” the Germans want to ensure that they are not throwing good money after bad.   In fact, the German taxpayers are rightly demanding so.  US based skeptics seem to have their anger misplaced when it comes to critiquing Germans for holding the line here for a bit more bite when it comes to lending cash to institutions that have caused the mess.

Growth

The final reason markets continue to react poorly to that laundry list of summits and proposals is that there is very little in terms of growth ideas that have been a part of the broader agenda.  Fiscal discipline alone does not save an economy that is in the midst of a paradox of thrift – just ask David Cameron.   Oh actually don’t ask David – he went home last week with his “bulldog spirit” in tact for the next election.

In the coming weeks we will need to see the following in order to stabilize market sentiment and begin the process of rebuilding investor confidence in Europe

1) Clarity around how the new treaty is operationalized

2) IMF involvement in the support of structured loans to Spain and Italy

3) The large scale sale of housing debt in Spain and Italy to the ECB (see Timmy G’s playbook)

4) In addition, a pledge by ECB to purchase all sovereign issues for the next five years.  Ahead of this pledge a collective issuance table would be completed allowing for a much smaller amount of issuance over that time period. (It’s funny what you can do when you live on less for a while)

5) A Euro-wide investment and infrastructure plan (See Alpert, Hockett, Roubini The Way Forward)

6) It would help if the ratings agencies held off for another three months – we all know European debts are a bit more risky at the moment thank you very much!
The grand European experiment is not dead.  It’s a clinical trial that came back from the FDA after 10 years of testing with some serious flaws.  Ask any good lab – they tend not to throw out the entire project…. They build something better and new.

Europe is in the process of so doing.